Worker Classification: Employee vs. Independent Contractor

Worker Classification in the News

Posted on 07-Jun-10 by The Timekeeper

You’ve probably heard a lot lately about the issue of classification of workers as employees or contractors. The issue has been covered in business publications, newsletters and myriad blog posts. Maybe you’ve been wondering why all the fuss all of a sudden.

What’s the motivation?

Well, for businesses, labor costs are much lower for a contractor than for an employee. No withholdings, no unemployment insurance, no benefits… there are powerful incentives for businesses to classify everyone possible as an “independent contractor.”

On the other hand, the government would prefer as many people as possible be classified as employees. It’s a lot easier (and less paperwork) to collect tax withholdings from one employer than to rely on potentially hundreds or thousands of individuals to make estimated tax payments.

So in order to classify someone as an independent contractor, the job they’re doing must meet certain criteria.

Thus, the crackdown.

Conflicting Criteria

The problem is, everybody seems to have their own ideas about what makes someone an independent contractor. The federal Department of Labor (DOL), the states, the IRS… and the criteria they use aren’t necessarily the same. Or even compatible with each other.

It’s possible, for instance, for somebody to be an independent contractor for the purposes of paying state unemployment tax, but an employee for the purpose of federal income tax withholdings.

Stepping Up Enforcement

These days, with our current economic issues, government agencies at all levels are trying to maximize their revenue. Many states and the IRS seem to be convinced they’re losing money from employers improperly classifying employees as contractors.

So they’re doing something about it.

Beginning in February 2010, the IRS launched a three-year audit initiatve, targeting small businesses for (among other things) compliance with the employee vs. independent contractor rules. They’ll be sharing information with several states and with the DOL.

The DOL has likewise targeted the classification of contractors as part of their Semiannual Regulatory Agenda for 2010. They propose to expand the recordkeeping requirements when you classify someone as a contractor. Under the new rules, which could go into effect as early as August, you’ll have to perform a formal classification review, document the results, share them with the worker and keep everything on file in case a DOL inspector wants to see them.

At the state level, Colorado, Illinois, Maryland, Massachusetts, New Jersey and New Mexico have passed laws targeting misclassification in designated industries. Iowa, Michigan, New York, Washington and Wisconsin have announced enforcement initiatives or created task forces charged with uncovering employee misclassification. Connecticut, Illinois, Maryland, Minnesota, Nebraska and New Jersey have enacted statutes increasing both civil and criminal penalties on employers for misclassifying employees as contractors.

So what’s a small business to do?

While each agency and government body seems to have somewhat different criteria, there are some general guidelines to keep in mind.

Independent contractors are intended to be temporary workers. The longer someone works for you, the more likely it is that they will be classified as a common-law employee in an audit.
Independent contractors generally are hired because of their specialized knowledge or skill to help you out with a particular issue. The more their work corresponds to the core function of your company, the more likely it is they’re an employee.
Independent contractors are supposed to be, well… independent. (Duh!) The more control you exert over when, where and how they do their work, the more likely it is they’ll be considered an employee.

Federal legislation has been introduced that is intended to help standardize the classification critiera. That would be a good thing, because it would make it easier for businesses to get it right when it comes to worker clasification.

On the other hand, the downside is that the proposed legislation would also increase the penalties for businesses that get it wrong.

In the meantime, if you have any contractors working for you now, and before you hire any additional contractors, consult with your labor law advisor. Make sure you thoroughly document all the factors that went into your classification decision so you have backup in case of an audit.

What about you? Do you employ contractors now? Has any of the news recently scared you away from hiring a contractor?